Counting Down to 2005: China’s Strong Currency Heightens Trade Debate

As the end of quotas nears, industry experts wonder if China will float its currency, and if the U.S. will clamp down on Chinese imports.

NEW YORK — As the end of quotas in 2005 looms closer, industry experts have two major questions on their mind regarding China, which has the potential to be the world’s dominant supplier of apparel.

Looking toward Beijing, they wonder if the Chinese government will float its currency, which many economists contend is currently undervalued by about 40 percent, making Chinese exports even more competitive abroad than they would otherwise be.

Looking at Washington, they wonder if the U.S. government will take advantage of loopholes in a China-U.S. trade deal that could allow the U.S. to clamp down tightly on Chinese imports if they disrupt the U.S. market.

Ira Kalish, the author of a recently released Deloitte Research study on China’s growing role in the world economy, has an answer for both questions: Yes.

“My own belief is that there will be a deal between the U.S. and China, where China agrees to revalue its currency and the U.S. agrees to hold off on doing anything protectionist,” Kalish said in a phone interview.

It’s a theory that met with a range of reactions among industry observers, with some calling it plausible and others dismissing it out of hand.

Currently, the Chinese government keeps the yuan pegged at an exchange rate of about 8.29 to the dollar. It has maintained this exchange rate by buying up foreign currency and keeping large amounts of yuan in circulation. China’s foreign currency reserves currently stand at about $325 billion, up from about $50 billion in 1994, the report said, citing International Monetary Fund data.

China’s fixed exchange rate has become a major political issue in the past few weeks. Treasury Secretary John Snow on Tuesday traveled to Beijing, where he urged Chinese officials to allow the yuan to float freely, according to wire-service reports. His comments came a day after top Chinese officials said they had no intention of floating the yuan.

“From what I understand, China is pretty determined not to float until they are good and ready,” said Conrad Lung, president of Sunnex Inc., a New York importer. “But the stakes are so high for both sides, I’m sure they’re going to find some way to lessen the impact.”

Lung said he believed it is important for the U.S. to recognize that, in dealing with China, it’s not necessarily in a position to act unilaterally. With its enormous population and growing economic power, China is perhaps positioned to become the world’s next superpower.

“The U.S. cannot say, ‘This is what I want to do,’ and expect China to say, ‘Fine,’” Lung said.

For their part, textile lobbyists said they regarded it as highly unlikely that China would float its currency anytime soon.

“They won’t do it,” said Charles Bremer, director of international trade at the American Textile Manufacturers Institute. “There is a lot more at stake here than just trade in textiles and clothing. It affects everything they export.”

He argued that he doesn’t believe the U.S. will actually push China all that hard to revalue its currency, because he said that nation is a major buyer of Treasury bonds.

“They are our creditors and we’re not going to take any action to upset them,” he said.

Jock Nash, Washington attorney for Spartanburg, S.C.-based Milliken & Co., said he considered the growing exchange-rate debate “a diversion” from the discussion of trade policy and its effect on U.S. employment.

“The problem with China is that they have 1.3 billion workers that are educated, dedicated and low wage,” he said. “They are going to beat us whether the yuan is correctly valued or not.”

He said even if China were to float its currency, it could come up with other ways to boost exports and limit imports if it wished to.

Some importers argued it’s also possible that China’s currency is fairly valued, reasoning that its apparel export prices are comparable to those of other developing nations.

“I don’t know that it is artificially low,” said Peter McGrath, president of purchasing at Plano, Tex.-based J.C. Penney Co. Inc., who also serves as head of the U.S. Association of Importers of Textiles & Apparel. “A lot of the merchandise we order from India, Pakistan and Vietnam is competitively priced.”

China’s currency, the yuan, is sometimes referred to as the renminbi, which is a denomination of yuan — similar to cents to the dollar. In the past, the country had maintained two currencies, with renminbi, literally “people’s money” intended for use of locals and yuan for foreigners. Those restrictions are no longer in place.

As the dollar in recent months has declined against other world currencies, including the euro and Japanese yen, China’s currency has slid in lockstep, putting further pressure on those economies.

“The U.S. has an interest in seeing China revalue its currency for a variety of reasons that go beyond apparel,” Kalish explained. He is global director of consumer business at the consulting firm and author of the 26-page report “The World’s Factory, China Enters the 21st Century,” which was released last month.

While the weak currency makes all kinds of Chinese consumer goods appear cheaper than they would otherwise be, it also artificially reduces the spending power of Chinese consumers. So, if the yuan and renminbi rose in value, the move would not just lift pressure off competing manufacturers in the U.S. and elsewhere in the world. It would also make China — with its population of 1.29 billion people — a more accessible market for many foreign suppliers.

At the same time, Kalish reasoned, China is desperate to prevent the U.S. from sharply curtailing rising Chinese imports in 2005, when the 146 World Trade Organization members will drop all quotas on textiles and apparel. As a part of the bilateral trade accord that paved the way for China’s WTO entry, the U.S. has a lot of leeway in limiting Chinese imports, either through tariffs or temporary quotas, if those imports prove a disruption to the U.S. market.

The American textile industry this year has been gaining ground in its effort to get the government to invoke those safeguard measures against China in several categories of merchandise that have already seen quotas lifted.

The Chinese, Kalish said, “are concerned that a protectionist move [by the U.S.] would hurt their apparel industry, which employs a lot of people.”

Apparel employment is particularly critical to China, he said, because the country is trying to reinvent its economy. For many years, millions of Chinese were employed in inefficient state-run enterprises that, according to observers, were managed with an eye toward employing the largest number of people, rather than operating in a cost-effective manner.

As China privatizes many of its state-run businesses, those companies will likely continue to lay off workers, creating an employment vacuum, Kalish said. The layoffs of workers in those companies, combined with the continuing migration of rural Chinese — who still represent about 70 percent of the population — into cities and residents of Western provinces into the industrial east, makes creating new jobs an urgent goal for the Chinese government, he said.

Kalish predicted that over the next decade, as many as 300 million Chinese could move into cities seeking employment, which he said “could well be the largest migration of any kind anywhere over human history.” A migration of that size would almost double the population of China’s cities.

The growth of China’s textile and apparel exports has been staggering — last year, its shipments to the U.S. rose 48.9 percent, according to Commerce Department data, making it the U.S.’s leading supplier in those categories with a 13.7 percent market share. But the report emphasized that apparel hasn’t been the sole, or even the primary, engine of China’s economic growth.

Last year, China’s net exports to the world in all categories of goods came to $325 billion, the report said, citing IMF data. That’s up from $92 billion in 1993. Over the past six years, exports have represented about 31.5 percent of China’s total growth in gross domestic product, which was up 8 percent last year.

China has also seen its exports of computers and other high tech products grow rapidly. In 2001, its exports of office and telecommunications equipment to the U.S., EU and Japan came to $45.32 billion, well ahead of its $32.46 billion in apparel shipments, the report said, citing WTO data. That technical business has grown by 122.1 percent since 1997, while apparel exports have grown 32.9 percent. (See related chart, this page.)

The report offered one reason why China’s electronics industry is growing so quickly: “Chinese companies are piggybacking on the technology developed by U.S. and Japanese companies. They spend a far lower share of revenue on research and thus have a cost advantage.”

Kalish said he believes the Chinese government is “more focused on high-tech areas” than on apparel manufacturing, both because there is less potential in that industry for the U.S. government to crack down on imports and because of the greater earnings potential.

Traditionally, industrializing economies move through industries in stages, starting with low-skilled, labor-intensive areas like apparel manufacturing, and from there moving on to higher-tech products. For instance, Japan and South Korea got their manufacturing engines turning by making garments, but have since largely moved on to other products.

In China, multiple classes of export-oriented industry are developing at the same time. Kalish said that’s a result of China’s immense size.

“You have almost an entire planet right there and so it’s possible to do a wide range of value-added processes in a country with that broad range of incomes and infrastructure and education levels,” he said. “In some ways, it’s similar to the way the U.S. was 100 years ago — a vast country that was capable of some very high-value-added processes, but also had a lot of cheap labor.”

Another factor that has allowed a relatively quick development of China’s industrial base is that many Chinese expatriates who had opened businesses elsewhere in the world in recent years have traveled back to their homeland to set up manufacturing bases. The capitalists, who have come from nearby Hong Kong and points as distant as New York’s Chinatown, have a powerful combination of business and cultural knowledge.

“These business people feel comfortable going into China. They speak the language, they were bold in putting capital into China and there has been a spiraling effect,” Kalish said. “Once one person goes in, someone else feels more comfortable, and it sort of builds on itself. The result is that, over time, a tremendous knowledge base has been developed. At the same time, the Chinese government invested a lot in the physical infrastructure.”

That training has made Chinese workers formidable competitors even though in some cases their wages have risen above those in other Asian nations. Citing Japan External Trade Organization data, the report said in 2003 the monthly wage for a worker in the growing production area around Shanghai was between $153 and $261 a month. That’s well over the comparable $108 a month prevailing wage in Jakarta, Indonesia. (See related chart, this page.)

Many retailers are turning their attention to Chinese production. The report offered the following examples:

Last year, Wal-Mart Stores Inc. purchased $12 billion worth of all classes of merchandise from China, a number it expects to climb to $15 billion this year and between $25 billion and $30 billion within five years. The buy was managed out of a procurement center in Shenzhen, just over the border from Hong Kong. By way of comparison, Wal-Mart in June reached a deal to import $800 million worth of goods from Brazil, which has seen its global exports pick up following a currency devaluation.

Carrefour last year bought $1.6 billion in Chinese goods, up 27 percent from 2001. The French retailer has moved its global purchasing center to China, where it has offices in 11 cities.

o last year bought about $500 million worth of Chinese merchandise, an amount it expects to triple in the next few years. It has opened a regional sourcing office in Shenzhen, as well.

Inc. buys about 14 percent of its goods from Hong Kong and China. The retailer last year had $14.5 billion in sales.

Kalish said he obtained the numbers from those four companies.

China’s apparel exports to the U.S. have grown swiftly — its 2001 imports of $9.28 billion were up 19.4 percent compared with $7.77 billion in 1997, the report said. But that rate of growth has been greatly outpaced by its growth to the EU, where it imported $8.43 billion in merchandise, up 36.5 percent from 1997. Its shipments to Japan came to $14.76 billion, up 40.7 percent

The fact that China’s apparel shipments to Japan exceed its shipments to the U.S. even though the U.S. has more than twice the population of Japan, illustrates China’s strong dominance of that market. China supplies 70 percent of Japan’s apparel imports, the report said. Japan does not regulate apparel imports with quotas.

Kalish said he considered it highly unlikely that China’s share of the U.S. market would ever get quite that high, since he believed that U.S. importers would continue to want some diversification, particularly into more local suppliers, like those in Latin America that can offer quicker turns and proximity advantages.

Still, he acknowledged that China’s share of the world apparel market is likely to grow sharply after quotas are dropped on Dec. 31, 2004. The report said China’s share of world apparel exports rose from 4 percent in 1980 to 16.7 percent in 1998, and predicted that figure could approach 45 percent by the second half of the decade.

One wild card that many sourcing executives have faced regarding Chinese exports is what will happen to quota charges when the quota system is dismantled. Quota rights are traded more or less as a commodity in China, and in categories where quota is scarce, such as cotton pants, can come to cost as much as $5 per garment by the end of a year.

The profits from quota-selling are believed to go to the Chinese government, which has led many to wonder whether it will put some other sort of comparable system in place to ensure it doesn’t lose a revenue source.

Kalish said he thinks otherwise: “They will be willing to let go of that and I think they will offset it by reducing their export subsidization.”

The report said those subsidies, which come in the form of a rebate on a value-added tax for goods that are exported, came to about $8.4 billion in 2000.

While China remains an attractive sourcing location and will likely become more so when quotas are lifted, Kalish warned there are two potential dangers for Western suppliers.

“There is the potential for a banking crisis,” he said. “The financial system is a mess.”

That’s because Chinese state-owned banks have often been pressured to lend money to struggling state-owned companies to prevent layoffs. While the banks are privatizing, they will need to change their credit standards, which may hurt state-run companies. Layoffs at those companies, combined with the rising tide of rural-to-urban immigration, has the potential to cause unrest.

“The biggest danger, in terms of social stability, is the wrenching process of reforming the state-run enterprises that employ a lot of people,” he said. “As long as foreign investment is coming in and the economy is growing, the excess labor will be absorbed. If the economy should slow down for any reason, or if there is a problem with investment, there could be a vast increase in unemployment.”

Kalish added that there’s one other important thing for U.S. companies to bear in mind as they structure their Chinese operations. A foothold in the country, even intended to produce goods for export, can also serve as a launching pad into the Chinese consumer market. There is a nascent middle class in China, which is buying cars, mobile phones and other consumer goods that are out of reach for many in a country with a per-capita GDP of $4,400.

Given the country’s massive population, Kalish said as a consumer market, China is “at the threshold of becoming quite important. It has been growing rapidly.”

In today’s cutthroat apparel industry, where executives fight over each nickel of cost in a garment, the birth of a significant middle class in a country is often a harbinger of the exit of U.S. importers — Mauritius, for instance, has recently weathered an exodus of manufacturers.

But considering the continuing flood of people out of rural farming districts and into cities, Kalish said China faces no shortage of low-cost workers. He said, “There’s at least another 20 years of significant apparel manufacturing in China.”